Chapter 18
Fixed Exchange Rates and
Foreign Exchange Intervention Add
Learning Objectives
18.1 Understand how a central bank must manage monetary policy so as to fix its currency’s value in the foreign exchange market.
18.2 Describe and analyze the relationship among the central bank’s foreign exchange reserves, its purchases and sales in the foreign exchange market, and the money supply.
18.3 Explain how monetary, fiscal, and sterilized intervention Add policies affect the economy under a fixed exchange rate.
18.4 Discuss causes and effects of balance of payments crises.
18.5 Describe how alternative multilateral systems for pegging exchange rates work
Preview
• Balance sheets of central banks
• Intervention in the foreign exchange markets and the money supply
• How the central bank fixes the exchange rate
• Monetary and fiscal policies under fixed exchange rates
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• Financial market crises and capital flight
• Types of fixed exchange rates: reserve currency and gold standard systems
Introduction
• Many countries try to fix or “peg” their exchange rate to a currency or group of currencies by intervening in the foreign
exchange markets.
• Many with a flexible or “floating” exchange rate in fact practice a managed floating exchange rate.
– The central bank “manages” the exchange rate from time Add to time by buying and selling currency and assets, especially in periods of exchange rate volatility. • How do central banks intervene in the foreign exchange markets?
Central Bank Intervention and the Money Supply
• To study the effects of central bank intervention in the foreign exchange markets, first construct a simplified balance sheet for the central bank. – This records the assets and liabilities of a central bank.
– Balance sheets use double-entry bookkeeping: each transaction enters the balance sheet twice.Add
Central Bank’s Balance Sheet (1 of 2)
• Assets
– Foreign government bonds (official international reserves)
– Gold (official international reserves)
– Domestic government bonds
– Loans to domestic banks (called discount loans in United
States)
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• Liabilities
– Deposits of domestic banks
– Currency in circulation (previously central banks had to give up gold when citizens brought currency to exchange)
Central Bank’s Balance Sheet (2 of 2)
• Assets = Liabilities + Net Worth
– If assume that net worth is constant, then
▪ An increase in assets leads to an equal increase in liabilities.
▪ A decrease in assets leads to an equal decrease in liabilities.
• Changes in the central bank’s balance sheet lead to changes Add in currency in circulation or changes in deposits of banks, which lead to changes in the money supply.
– If their deposits at the central bank increase, banks are usually able to use these additional funds to lend to customers, so amount of money in circulation increases.
Assets, Liabilities, and the Money
Supply (1 of 2)
• A purchase of any asset by the central bank will be paid for with currency or a check written from the central bank,
– both of which are denominated in domestic currency, and
– both of which increase the supply of money in circulation.
– The transaction leads to equal increases of assets and Add liabilities.
• When the central bank buys domestic bonds or foreign bonds, the domestic money supply increases.
Assets, Liabilities, and the Money
Supply (2 of 2)
• A sale of any asset by the central bank will be paid for with currency or a check written to the central bank,
– both of which are denominated in domestic currency.
– The central bank puts the currency into its vault or reduces the amount of deposits of banks, – causing the supply of money in circulation to shrink.
Add – The transaction leads to equal decreases of assets and liabilities.
• When the central bank sells domestic bonds or foreign bonds, the domestic money supply decreases. Foreign Exchange Markets
• Central banks trade foreign government bonds in the foreign exchange markets.
– Foreign currency deposits and foreign government bonds are often substitutes: both are fairly liquid assets denominated in foreign currency. – Quantities of both foreign currency deposits and foreign government bonds that are bought and sold Add influence the exchange rate.
Sterilization
• If the central bank sells foreign bonds in the foreign exchange markets, it can buy domestic government Add bonds in bond markets—hoping to leave the amount of money in circulation unchanged.
Table 18.1 Effects of a $100 Foreign Exchange Intervention: Summary
Domestic Central Bank’s Action Effect on Domestic Money Supply Effect on Central Bank’s Domestic Assets Effect on Central Bank’s Foreign Assets
Nonsterilized foreign exchange purchase +$100 ment Project E +$100
Sterilized foreign exchange purchase 0 htt
Negative $100
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+$100
Nonsterilized foreign exchange sale $100
Negative $100
Sterilized foreign exchange sale 0 +$100 $100Negative $100
(1 of 4)
• To fix the exchange rate, a central bank influences the quantities supplied and demanded of currency by trading domestic and foreign assets, so that the exchange rate (the price of foreign currency in terms of domestic currency) stays constant.
• Foreign exchange markets are in equilibrium when
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• When the exchange rate is fixed at some level E0 and the market expects it to stay fixed at that level, then
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(2 of 4)
• To fix the exchange rate, the central bank must trade foreign and domestic assets in the foreign exchange market until
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• Alternatively, we can say that it adjusts the quantity of monetary assets in the money market until the domestic interest rate equals the foreign interest rate, given the level Add of average prices and real output:
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(3 of 4)
• Suppose that the central bank has fixed the exchange rate at E0 but the level of output rises, raising the
demand of real monetary assets.
• This is predicted to put upward pressure on interest rates and the value of the domestic currency.
Add
• How should the central bank respond if it wants to fix exchange rates?
(4 of 4)
• The central bank should buy foreign assets in the foreign exchange markets,
– thereby increasing the domestic money supply, – thereby reducing interest rates in the short run.
– Alternatively, by demanding (buying) assets denominated in foreign currency and by supplying
(selling) domestic currency, the price/value of foreign Add currency is increased and the price/value of domestic currency is decreased.
Figure 18.1 Asset Market Equilibrium With a Fixed Exchange Rate, E0
E sub 0
To hold the exchange rate fixed at E0 when output rises from Y Y1 to 2, the central bank must purchase foreign
assets and thereby raise the money supply from M M1 to 2.
Monetary Policy and Fixed Exchange Rates
• When the central bank buys and sells foreign assets to keep the exchange rate fixed and to maintain domestic interest rates equal to foreign interest rates, it is not able to adjust domestic interest rates to attain other goals.
– In particular, monetary policy is ineffective in influencing output and employment.
Add Figure 18.2 Monetary Expansion Is Ineffective Under a Fixed Exchange Rate
Add
Initial equilibrium is shown at point 1, where the output and asset markets simultaneously clear at a fixed exchange rate of E0 and an output level of Y1. Hoping to increase output to Y2, the central bank decides to increase the money supply by buying domestic assets and shifting AA AA1 to 2. Because the central bank must maintain E0, however, it has to sell foreign assets for domestic currency, an action that decreases the money supply immediately and returns AA2 back to AA1. The economy’s equilibrium therefore remains at point 1, with output unchanged at Y1.
Fiscal Policy and Fixed Exchange Rates in the Short Run
Figure 18.3 Fiscal Expansion Under a Fixed Exchange Rate
Fiscal expansion (shown by the shift from DD DD1 to 2) and the intervention that accompanies it (the shift from AA AA1 to 2) move the economy from point 1 to point 3.
Fiscal Policy and Fixed Exchange Rates in the Long Run (1 of 2)
• When the exchange rate is fixed, there is no real appreciation of the value of domestic products in the short run.
• But when output is above its potential level, wages and prices tend to rise in the long run. • A rising price level makes domestic products more expensive:
a real appreciation falls .Add
– Aggregate demand and output decrease as prices rise: DD curve shifts left.
– Prices tend to rise until employment, aggregate demand, and output fall to their normal (potential or natural) levels.
Fiscal Policy and Fixed Exchange Rates in the Long Run (2 of 2)
• Prices are predicted to change proportionally to the change in the money supply when the central bank intervenes in the foreign exchange markets.
– AA curve shifts down (left) as prices rise. – Nominal exchange rates will be constant (as long as the fixed exchange rate is maintained), but the real
exchange rate will be lower (a real appreciation).Add
Devaluation and Revaluation
• Devaluation and revaluation refer to changes in a fixed exchange rate caused by the central bank.
– With devaluation, a unit of domestic currency is made less valuable, so that more units must be exchanged Add for 1 unit of foreign currency.
– With revaluation, a unit of domestic currency is made more valuable, so that fewer units need to be exchanged for 1 unit of foreign currency.
Devaluation
• For devaluation to occur, the central bank buys foreign assets, so that domestic monetary assets increase and domestic interest rates fall, causing a fall in the rate return on domestic currency deposits.
– Domestic products become less expensive relative to foreign products, so aggregate demand and output increase. Add – Official international reserve assets (foreign bonds) increase.
Figure 18.4 Effect of a Currency Devaluation
When a currency is devalued from E E0 to 1, the economy’s equilibrium moves from point 1 to point 2 as both output and the money supply expand.
(1 of 6)
• When a central bank does not have enough official international reserve assets to maintain a fixed exchange rate, a balance of payments crisisresults. – To sustain a fixed exchange rate, the central bank must have enough foreign assets to sell in order to satisfy the demand of them at the fixed exchange rate. Add
Financial Crises and Capital Flight (2 of 6)
1. This expectation or fear only makes the balance of payments crisis worse: – Investors rush to change their domestic assets into Add foreign assets, depleting the stock of official international reserve assets more quickly.
(3 of 6)
2. As a result, financial capital is quickly moved from domestic assets to foreign assets: capital flight.
– The domestic economy has a shortage of financial capital for investment and has low aggregate demand.
3. To avoid this outcome, domestic assets must offer high interest rates to entice investors to hold them. – The central bank can push interest rates higher by reducing the Add money supply (by selling foreign and domestic assets).
Figure 18.5 Capital Flight, the Money Supply, and the Interest Rate
Add
To hold the exchange rate fixed at E0 after the market decides it will be devalued to E1, the central bank must use its
reserves to finance a private financial outflow that shrinks the money supply and raises the home interest rate.
(4 of 6)
• Expectations of a balance of payments crisis only worsen the crisis and hasten devaluation.
– What causes expectations to change? ▪ Expectations about the central bank’s ability and willingness to maintain the fixed exchange rate.
▪ Expectations about the economy: shrinking
demand of domestic products relative to foreign Add products means that the domestic currency should become less valuable.
• In fact, expectations of devaluation can cause a devaluation: a self-fulfilling crisis.
(5 of 6)
• What happens if the central bank runs out of official international reserve assets (foreign assets)?
• It must devalue the domestic currency so that it takes more domestic currency (assets) to exchange for 1 unit of foreign currency (asset).
– This will allow the central bank to replenish its foreign assets by buying them back at a devalued rate,Add – increasing the money supply,
– reducing interest rates,
– reducing the value of domestic products, – increasing aggregate demand, output, and employment over time.
(6 of 6)
domestic currency (to increase the money supply) to prevent high interest rates, but this only depreciates
the domestic currency more. – the central bank generally cannot satisfy the goals of low domestic interest rates (relative to foreign interest Add rates) and fixed exchange rates simultaneously.
Source: Swiss National Bank.
Interest Rate Differentials (1 of 3)
• For many countries, the expected rates of return are not E Ee the same: R R AssE .ignment Project Exam HelpWhy?
• Default risk:
The risk that the country’s borrowers will default on their loan repayments. Lenders therefore require a higher interest rate to Add compensate for this risk.
• Exchange rate risk:
If there is a risk that a country’s currency will depreciate or be devalued, then domestic borrowers must pay a higher interest rate to compensate foreign lenders.
Interest Rate Differentials (2 of 3)
• Because of these risks, domestic assets and foreign assets are not treated the same. – Previously, we assumed that foreign and domestic currency deposits were perfect substitutes: deposits everywhere were treated as the sametype of investment, because risk and liquidity of the assets were assumed to be the same.
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– Investors consider these risks, as well as rates of return on the assets, when deciding whether to invest.
Interest Rate Differentials (3 of 3)
• A difference in the risk of domestic and foreign assets is one reason why expected rates of return are not equal across countries:
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where is called a risk premiumAdd , an additional amount needed to compensate investors for investing in risky domestic assets.
• The risk could be caused by default risk or exchange rate risk.
The Rescue Package: Reducing rho
• The United States and IMF set up a $50 billion fund to guarantee the value of loans made to Mexico’s government,
– reducing default risk, – and reducing exchange rate risk, since foreign loans could act as official international reserves to stabilize the exchange rate if necessary.
• After a recession in 1995, the economy began to recover.Add
– Mexican goods were relatively inexpensive, allowing production to increase.
– Increased demand of Mexican products relative to demand of foreign products stabilized the value of the peso and reduced exchange rate risk.
Figure 18.7 Effect of a Sterilized Central Bank Purchase of Foreign
Assets Under Imperfect Asset Substitutability
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A sterilized purchase of foreign assets leaves the money supply unchanged but raises the risk-adjusted return that domestic currency deposits must offer in equilibrium. As a result, the return curve in the upper panel shifts up and to the right. Other things equal, this depreciates the domestic currency from E E1 to 2.
Types of Fixed Exchange Rate Systems
1. Reserve currency system: one currency acts as official international reserves – The U.S. dollar was the currency that acted as official international reserves from under the fixed exchange rate system from 1944 to 1973.
– All countries except the United States held U.S. dollars as the means to make official international payments.Add
2. Gold standard: gold acts as official international reserves that all countries use to make official international payments.
Reserve Currency System
• From 1944 to 1973, central banks throughout the world fixed the value of their currencies relative to the U.S. dollar by buying or selling domestic assets in exchange for dollar denominated assets.
• Arbitrage ensured that exchange rates between any two currencies remained fixed. – Suppose Bank of Japan fixed the exchange rate at 360¥ US$1
and the Bank of France fixed the exchange rate atAdd 5Ffr US$1.
360¥
US$1 = 72¥. – The yen/franc rate was 5Ffr 1Ffr
– If not, then currency traders could make an easy profit by buying currency where it was cheap and selling it where it was expensive.
Gold and Silver Standard
• Bimetallic standard: the value of currency is based on both silver and gold.
• The United States used a bimetallic standard from 1837 to 1861.
• Banks coined specified amounts of gold or silver into the national currency unit.
– 371.25 grains of silver or 23.22 grains of gold could be turned into a silver or a gold dollarAdd – So gold was worth 371.25 / 23.22 16 times as much as silver.
– See www.micheloud.com for a fun description of the bimetallic standard, the gold standard after 1873, and the Wizard of Oz!
Figure 18.8 Growth Rates of International
Reserves
Annualized growth rates of international reserves did not decline sharply after the early 1970s. Recently, developing countries have added large sums to their reserve holdings, but their pace of accumulation has slowed starting with the crisis years of 2008–2009. The figure shows averages of annual growth rates.
Source: International Monetary Fund.
Figure 18.9 Currency Composition of Global Reserve Holdings
While the euro’s role as a reserve currency increased during the first decade of its existence, it has taken a hit after the euro crisis. The dollar remains the overwhelming favorite. Source: International Monetary Fund, Currency Composition of Foreign Exchange Reserves (COFER), at http://www.imf.org/external/np/sta/cofer/eng/index.htm . These data cover only the countries that report reserve composition to the IMF.
(1 of 4)
1. Changes in a central bank’s balance sheet lead to changes in the domestic money supply.
– Buying domestic or foreign assets increases the domestic money supply.
– Selling domestic or foreign assets decreases the domestic money supply.
Add
2. When markets expect exchange rates to be fixed, domestic and foreign assets have equal expected returns if they are treated as perfect substitutes. (2 of 4)
3. Monetary policy is ineffective in influencing output or employment under fixed exchange rates.
4. Temporary fiscal policy is more effective in influencing output and employment under fixed exchange rates, compared to under flexible exchange rates.
Add (3 of 4)
central bank can no longer maintain a fixed exchange rate: self-fulfilling crises can occur.Add
(4 of 4)
8. Under a reserve currency system, all central banks but the one that controls the supply of the reserve currency trade the reserve currency to maintain fixed exchange rates. 9. Under a gold standard, all central banks trade gold to maintain fixed exchange rates.
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Figure 18A1.1 The Domestic Bond Supply and the Foreign
Exchange Risk Premium Under Imperfect Asset
Substitutability
An increase in the supply of domestic currency bonds that the private sector must hold raises the risk premium on domestic currency assets.
Figure 18A2.1 How the Timing of a Balance of Payments Crisis Is Determined
The market stages a speculative attack and buys the remaining foreign reserve stock FT at time T, which is when the shadow floating exchange rate
ETS just equals the pre-collapse fixed exchange rate E0.
